Why 2019 will be a bellwether year for tech entrepreneurs in China

The Wall Street Journal reported recently that Americans who flocked to China 15 to 20 years ago to build factories and open restaurant chains have despaired of the soaring labor costs, creeping regulation and the sour mood brought about by the Trump administration’s hostility toward China.

As many old-school US business people and merchants give up on China, new-economy entrepreneurs and digital nomads from around the world are settling down in China’s main metropolitan centers.

The turmoil of past weeks appears, paradoxically perhaps, to strengthen the resolve of Western startup founders who have already made the decision to grow their companies in China. The vast market size; founders’ assessment that the country’s opening up is for real—these are a call to action for gutsy folk to grab the opportunity here and now and set themselves on path to win first-movers’ luscious fruit.

Startup founders from Europe, Israel, the US and Asia are a growing constituency that is making a home of sorts in China’s first and second-tier cities. China’s dominant role in sectors such as automotive, manufacturing and ecommerce is pushing these founders to allocate scarce resources to what is still considered a frontier, albeit one that can no longer be ignored.

Founders from Europe, with fewer venture capitalists and angel investors to go by, typically form a company, garner some traction and soon thereafter set up headquarters or key office in one of China’s main tech hubs.

Israeli founders, with a dense VC ecosystem to power their ventures, usually take a different route: Having been trained in Silicon Valley craftsmanship, they first raise initial capital and reach the commercial stage in the US before making inroads into China.

Nipped in the bud?

How will the US-China trade war and the slowdown in China’s economy affect the prospects of these foreign hopefuls? Now that Chinese investors and laowai (foreigners) are for the first time beginning to come together in China in a meaningful way, will these seemingly worsening conditions nip this experiment in the bud?

Neil Shen, the founding and managing partner of Sequoia Capital China, thinks the answer is a resounding no. Speaking at the World Internet Conference in Wuzhen, China, last November, he said that the country’s digital ecosystem will not be affected by the trade war. Shen’s assertion that there is no “capital winter” is backed up by numbers: VC funding in China surpassed $100 billion in 2018, a record.

Two telling figures give a more nuanced picture: With a sharp drop in the number of deals made, the median equity amount invested in a Chinese VC-backed company, according to Dow Jones Venture Capital Report, set a record high in the fourth quarter of 2018, hitting $12.3 million.

In the US a similar trend is observed. According to figures produced by PitchBook and the National Venture Capital Association (NVCA), in 2018 investors deployed larger amounts of capital across fewer VC deals, contributing to record-high deal sizes and a decline in deal counts.

Shen of Sequoia China went on to say that the current situation presents both challenges and opportunities. While many in the Chinese ecosystem to date only went for the low-hanging fruit and had only Plan A, many are now seeking Plan B, which bodes well for the development of sectors like deep tech.

As Plan B unfolds, it seems, Chinese VCs will no longer go only for the easy pickings, the local startups, but will be forced in their search for potential unicorns to reach farther afield for foreign-bred startups that specialize in game changing technologies in artificial intelligence, computer vision, natural language processing and cloud computing. Government lends further weight to this by enacting favorable policy and pledging money to foreign companies, entrepreneurs and scientists who come to China.

True, a negative scenario may prevail, by which economic malaise and restrictions on foreign currency transfers will make China inhospitable in the foreseeable future. Still a huge consumer market and the intense competition, which fuel China’s tech boom, are unlikely to let down any time soon and may very well continue—with fits and starts—to drive the country up the value chain.

One example of a startup that presses on is YooSourcing, founded in 2017 by Milad Nouri, a native of France, and four cofounders from India, China and France. With 10 employees in its Hangzhou headquarters, YooSourcing uses crowd verification, matchmaking driven by machine learning and instant messaging to help optimize the match between wholesale buyers and sellers. A sales and marketing team will be hired this year in Hong Kong. “We are expecting to triple the size of our team in 2019,” says Nouri.

Specter of diminished US prospects

As they settle into a poorly understood environment, foreign founders in China face new forms of uncertainty and potential friction on core issues, decision-making and intellectual property, which are routinely resolved through standard contracts in the US and Europe. For example, a problem arises when Chinese investors expect to put their money into a Chinese joint venture company, but foreign founders worry that in case of conflict they may get less than a fair trial in the Chinese court system.

“Any issues related to IP and decision-making brought on by Chinese shareholders can impede the global operations of the company,” says Nouri of YooSourcing.

IP concerns in China are shifting from theft, which has been the main concern for decades, to unforeseen complications. To be fair, the country is making significant progress in IP protection, much of it thanks to its own tech champions that lead in the number of patents registered—Huawei was the top filing company at the European Patent Office in 2017.

A specialized IP court system, opened in 2014 in Beijing, Shanghai and Guangzhou, has tried 237,242 cases in 2017, a surge of 33% over 2016.

What haunts leaders of Israeli “deep tech” startups is the specter of obligations related to their presence in China that somehow spin out of control and create legal and commercial obstacles down the road in the US, which might diminish prospects for further fundraising and financial exit in the US.

“If we take in RMB from Chinese investors for our Beijing-based subsidiary, will they make unwarranted claims over our IP that resides with the parent company overseas?” asks Kobi Marenko, co-founder and CEO of Arbe Robotics, a maker of high-resolution 4D imaging radar for autonomous vehicles, who has raised around $23 million for his company from Israeli VCs.

Shay Ronen, founder of Tel Aviv-based Navin offers this perspective: “Before I take a single RMB into my Chinese subsidiary,” said Ronen, “I have to pay lawyers tens of thousands of dollars to write up and negotiate elaborate contracts that clearly stipulate the status and rights of our Chinese shareholders.” That is a great burden for an early stage startup.

Still, good tech entrepreneurs do not shy away from adversity—they are prepared to face long odds if they see the opportunity.